2 Pair Trades for an Uncertain Market - 12694 views

MINNEAPOLIS (Stockpickr) -- My heart goes out to buy-and-hold investors. The last decade has proven that simply holding stocks forever does not work. Both the Dow Jones Industrial Average and the S&P 500 indices have barely budged since 2001. Now, after six straight weeks of losses, we are seeing once again why it pays to trade instead of blindly holding and hoping for the best.

The defenders of buy-and-hold investing will tell you that it is impossible to time the market. I disagree. If you look at key inflection points over the years, it is easy to see a pattern -- an entirely predictable pattern. Using valuation as a guide and understanding where the economy is in the business cycle can save you from the death clutch of buy-and-hold.

Investors should be reminding themselves every day that they are in the stock market to make money -- not to lose it. Having that singular focus should make it easier to move in and out of stocks. The best way to achieve that goal in my opinion is to utilize pair trades, in which a long position is accompanied by a corresponding short position.

With the market down nearly 10% since late April, having select short positions in your portfolio would have paid off significantly. The net/net of a pair trade strategy is to keep your returns above zero no matter the market conditions. If you are really good at stock picking, you can even beat the market when stocks are going up.

Long Zumiez: Clothing retailer to the X-Game set Zumiez (ZUMZ) is where the action is in trendy teen and young adult apparel. The company captured the imagination of that key demographic and enjoyed solid growth as a result. Its shares have gained more than 170% over the last two years.

Those gains have become losses in 2011 thanks to questions about the sustainability of the current recovery. Zumiez is down 12% this year. More troubling -- or opportunistic, depending on your view -- is that the stock has crashed since the end of May. On May 31, Zumiez shares closed at $30.38 per share. In two weeks, the stock is down a jaw dropping 23%.

The reason for the selling is directly related to Wall Street downgrades of the stock -- no matter that the company beat earnings results for the period ended April 30 by 4 cents per share. Combined with poor market sentiment, the downgrades were enough to push investors to the exits.

I would ignore the noise and use the selling as a buying opportunity based on valuation. Analysts expect Zumiez to make $1.11 in the current fiscal year, with that number growing by 18% in the following year. At current prices, shares trade for about 20 times current-year estimates. The froth has been removed from this growth stock.

From a pair-trade standpoint, the downside risk is limited compared with other apparel retailers. I would buy Zumiez at these prices, and I expect the company to continue beating earnings estimates over the next few quarters.

Short Gap: I had the chance to hear a sound bite from the CEO of Gap (GPS) earlier this week. Responding to a reporter’s question on CNBC regarding the current state of affairs at the company, the CEO calmly stated that he and his management team are intently focused on the long term and not the short term.

Given that the company has struggled to grow of late, the answer is surprising. While I can appreciate long-term strategic thinking, the comment strikes me as silly and dangerous. It would be like the captain of the Titanic saying not to worry about the hole in the ship because in the long term, a rescue boat would come to save the day -- no matter that the boat would never make it through the night.

It has been my experience that companies that are in decline or stagnant tend to stay that way. It is a rare and remarkable event for a company to turn itself around. Sure, it could happen, but it's unlikely. From that standpoint, Gap is an excellent stock to sell short in a pair trade.

The difficulties at Gap were reinforced with May retail sales numbers. The company announced that sales for the month fell by 4%, missing analyst expectations. In addition to sales struggles, the company is facing profit pressures due to rising material costs. Will it be able to pass along higher prices to consumers?

The safe assumption would be that no, it cannot. Analysts have slashed profit expectations for 2011. For the current year ending Jan. 31, 2012, the estimate is for Gap to post a profit of $1.44. A month ago, the average estimate was at $1.83. Where things might get dicey for Gap is if the current soft patch in the economy gets worse. There are simply more negatives than pluses with this stock.

Long Apple/Short Research in Motion

Long Apple: If there was ever one stock to own in the market it would be Apple (AAPL). The technology company continues to innovate and dictate where the technology market is moving. Its key products in wireless phones, tablets and personal computers have yet to reach their full market potential. Apple is simply a moneymaking leader that is not to be doubted.

Fortunately for pair trade investors, doubt is being cast on the company. Its shares are stuck in the mud, moving a mere 1.3% higher despite the company's crushing earnings estimates and growing strongly. If ever there was a company to deserve a premium valuation, it would be Apple.

Part of the reason for the tepid performance is the health of CEO Steve Jobs. Jobs is on medical leave but is far from being completely absent from the company. Selling based on fear of losing Jobs is misguided at best. Recently Jobs emerged from hibernation to announce Apple’s move to the cloud, an exciting development that should have investors thrilled.

One only needs to take a look at other technology names participating in the cloud space in order to be enthused. For example, Salesforce.com trades for 75 times fiscal year 2012 earnings estimates. Assign a similar but lower multiple of 50 to Apple’s earnings estimate for 2012, and you get a stock trading for more than $1,400 per share.

Forget about cloud and focus on what is known about Apple. It has beaten estimates by a wide margin. That trend should continue for the foreseeable future. Analysts have the company growing by 16% from the current fiscal year to 2012. At current prices, shares trade for a ridiculously cheap 13 times. Apple is an easy long at these prices.

Short Research in Motion: Technology companies can be notoriously volatile. Only the best and proven innovators such as Apple grow at a consistently high rate. What was hot for the moment can be cold for the next. That seems to be the fate of Research In Motion (RIMM).

RIM's BlackBerry device captured the imagination of the executive and Wall Street set in the 1990s and has enjoyed a free ride for much of the past decade. Unfortunately for RIM, the ride ended with Apple’s iPhone. From the moment the iPhone launched, Research In Motion has been scrambling to find a competitive solution to increased competition.

I doubt there is one. There competition not only from Apple but also from the Android device. Research In Motion's story could be similar the story of another once-popular handheld device company, Palm -- a story that ended with the sale of the company at a severely discounted stock price.

RIM shares have already collapsed, but there is more room to fall. The stock is down almost 40% so far this year and is likely to fall further. Do not be fooled by a low valuation. Wall Street has yet to give up on the company based on still-robust earnings estimates. For this year and next, the company is expected to make $6.36 and $6.77 per share, respectively. The analysts are correct on the minimal growth assumption, but most likely wrong on the profit estimates.

Apple and Android are battling to steal market share in the handheld device market. When they win, Research In Motion loses. I would short this stock in tandem with a long of Apple. This is a pair trade that I expect to do very well.

At the time of publication, author had no positions in stocks mentioned.

Jamie Dlugosch is a founder and contributor to MainStreet Investor and MainStreet Accredited Investor. Formerly, he was president and CEO of Al Frank Asset Management. He has contributed editorially to The Rational Investor, The Prudent Speculator, Penny Stock Winners and InvestorPlace Media.